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The of

Insights on globalization from a novel approach

Carol Graham

Introduction

The economics of happiness is an approach to assessing which combines the techniques typically used by with those more commonly used by psychologists. It relies on surveys of the reported well- being of hundreds of thousands of individuals across countries and conti- nents. It also relies on more expansive notions of than does conventional economics, highlighting the role of non-income factors that well-being. It is well suited to informing questions in areas where revealed preferences provide limited information, such as the welfare effects of inequality and of macroeconomic policies such as and . One such question is the gap between economists’ assess- ments of the aggregate benefits of the globalization process and the more pessimistic assessments that are typical of the general public (see Rodrik, 1997; O’Rourke and Sinott, 2002; and Graham and Pettinato, 2002).1 Standard analyses based on aggregate, income-based measures provide important benchmarks for assessing the impact of globalization on poverty

Carol Graham is Senior Fellow in the Economic Studies Program at The Brookings Institution and Professor of at the University of Maryland. The paper draws heavily on a chapter in the forthcoming edition of the New Palgrave Dictionary of Economics, edited by Steven Durlauf and Larry Blume, and is adapted and reproduced with permission of Palgrave Macmillan. The author would like to thank Henry Aaron, , Joshua Epstein, Andrew Felton, , and George Perry for helpful comments.

1 There is some evidence that attitudes about globalization are more negative among the publics in developed than in most developing countries. (Rodrik, 1997). O’Rourke and Sinott (2002) find that public support for free is higher among skilled than unskilled labor in the developed ; Graham and Pettinato (2002) find a similar trend for respondents in Latin America. The Pew Global Attitudes (2002), meanwhile, which surveyed 38,000 people in 44 nations (both developing and developed), found that the majority of respondents in the poll thought highly of international organizations, such as the WTO, and multinational corporations, while anti-globalization protestors were held in low esteem. At the same time, the majority of the public felt that many of the problems that the protestors highlight, such as the availability of jobs and the gap between the rich and the poor, are worsening.

WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 41 Carol Graham and inequality. This paper highlights the extent to which a novel approach—the economics of happiness—provides alternative measures of well-being, which in turn highlight aspects of the process that also matter to welfare. These include the insecurity caused by short-term movements in and out of poverty; the welfare effects of effects of changes in the dis- tribution over the life or earnings cycle and/or distributional shifts at the sector, cohort, and neighborhood level; and changes in reported well-being that are driven by the widespread increase of global information and its effects on local reference norms.

The economics of happiness—the approach

While psychologists have been using surveys of reported well-being to study happiness for years, economists only recently ventured into this arena. Early economists and philosophers, ranging from to Bentham, Mill, and Smith, incorporated the pursuit of happiness in their work. Yet as economics grew more rigorous and quantitative, more parsi- monious definitions of welfare took hold. Utility was taken to depend only on income as mediated by individual choices or preferences within a rational individual’s monetary budget constraint. Even within a more orthodox framework, focusing purely on income can miss key elements of welfare—as numerous economists have noted over time. People have different preferences for material and non-material . They may choose a lower paying but more personally rewarding job, for example. They are nonetheless acting to maximize utility in a clas- sically Walrasian sense. The study of happiness or subjective well-being is part of a more gen- eral move in economics that challenges these narrow assumptions. The introduction of bounded rationality and the establishment of , for example, have opened new lines of research. —which represents one new direction—relies on more expan- sive notions of utility and welfare, including interdependent utility func- tions, procedural utility, and the interaction between rational and non-rational influences in determining economic behavior. Richard Easterlin was the first modern to re-visit the concept of happiness, beginning in the early 1970s. More generalized took hold in the late 1990s (see, among others, Easterlin, 1974, 2003;

42 WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 The Economics of Happiness

Blanchflower and Oswald, 2004; Clark and Oswald, 1994; Frey and Stutzer, 2002a; Graham and Pettinato, 2002; Layard, 2005). The economics of happiness does not purport to replace income-based measures of welfare, but instead to complement them with broader meas- ures of well-being. These measures are based on the results of large-scale surveys, across countries and over time, of hundreds of thousands of indi- viduals who are asked to assess their own welfare. The surveys provide information about the importance of a range of factors which affect well- being, including income but also others such as , marital and status, and civic trust. The approach, which relies on expressed preferences rather than on revealed choices, is particularly well suited to answering questions in areas where a revealed preferences approach provides limited information. Indeed, it often uncovers discrepancies between expressed and revealed preferences. The latter cannot fully gauge the welfare effects of particular policies or institutional arrangements which individuals are powerless to change. Examples of these include the welfare effects of inequality, envi- ronmental degradation, and macroeconomic policies such as inflation and unemployment. Sen’s capabilities-based approach to poverty, for example, highlights the lack of capacity of the poor to make choices or to take cer- tain actions. In many of his writings, he criticizes economists’ excessive focus on choice as a sole indicator of behavior (Sen, 1995). Understanding the limits to choice approaches—and willingness to use the information contained in preferences expressed in surveys—may help us better understand the divergence between economists’ generally posi- tive assessments of the globalization process and those of the typical lay- man or woman experiencing the process. While the former are based on standard measures of the aggregate benefits of the process, the latter tend to be based on individual experiences. These are influenced by changes in opportunity sets and reward structures, which in turn vary across cohorts and can bring new vulnerabilities and dislocation for many individuals. As these changes are driven by forces which individuals are powerless to influence, a choice approach has limits in capturing their welfare effects. Another area where a choice approach is limited and happiness surveys can shed light is the welfare effects of addictive behaviors such as smok- ing and drug abuse. It can broaden our understanding of excessive con- sumption and/or variance in response to public health information across

WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 43 Carol Graham

age and income cohorts, for example (as in the case of obesity, which is increasingly recognized as a major public health problem in the U.S.). Happiness surveys are based on questions in which the individual is asked “generally speaking, how happy are you with your life?” or “how satisfied are you with your life?”, with possible answers on a four to seven point scale.2 This approach presents several methodological challenges. Critics used to defining welfare or utility in material or income terms bemoan the lack of precise definition in these questions (for a fuller description of these, see Bertrand and Mullanaithan, 2001; Frey and Stutzer, 2002b). To minimize order bias, for example, happiness questions must be placed at the beginning of surveys. As with all economic meas- urements, the answer of any specific individual may be biased by idiosyn- cratic, unobserved events. Bias in answers to happiness surveys can also result from unobserved traits and correlated measurement errors (which can be corrected via individual fixed effects if and when panel data are available). Other concerns about correlated unobserved variables are common to all economic disciplines. Accuracy in reporting is another issue in using perceptions data. Responses can be very biased by the phrasing or the placement of ques- tions in the survey. Another problem in reporting is bias introduced by dif- ferent or changing reference norms. If you ask people how much income would they need to make ends meet, and/or to be happy, they usually base their answers on their existing income and increase it by some proportion, regardless of the absolute level.3 Despite the potential pitfalls, cross sections of large samples across countries and over time find remarkably consistent patterns in the deter- minants of happiness. Many errors are uncorrelated with the observed variables, and do not systematically bias the results. Psychologists, mean- while, find validation in the way that people answer these surveys based in physiological measures of happiness, such as the frontal movements in the and in the number of “genuine”—Duchenne—smiles (Diener and Seligman, 2004).

2 Psychologists have a for questions. Yet answers to happiness and life satisfaction questions correlate quite closely. For British data for 1975–1992, where both questions are available, Blanchflower and Oswald (2004) get a correlation coefficient of .56; for Latin American data for 2000–2001, in which alternative phrasing was used in different years, Graham and Pettinato (2002) find it is .50. 3 A survey conducted by Richard Webb and Cuanto and Lima in the 1980s, for example, found that workers of all income levels consistently doubled their current income when asked how much income would be “enough”.

44 WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 The Economics of Happiness

Microeconometric happiness equations have the standard form: Wit = α β ε + xit + it, where W is the reported well-being of individual i at time t, X is a vector of known variables including sociodemographic and socio- economic characteristics. Unobserved characteristics and measurement errors are captured in the error term. Because the answers to happiness surveys are ordinal rather than cardinal, they are best analyzed via ordered logit or probit equations. These regressions typically yield lower R-squares than economists are used to, reflecting the extent to which and other components of true well-being are driving the results, as opposed to the variables that we are able to measure, such as income, , and marital and employment status.4 The availability of panel data in some instances, as well as advances in econometric techniques, are increasingly allowing for sounder analysis (Van Praag and Ferrer–i–Carbonell, 2004). The coefficients produced from ordered probit or logistic regressions are remarkably similar to those from OLS regressions based on the same equations. While it is impossible to measure the precise effects of independent variables on true well-being, happiness researchers have used the OLS coefficients as a basis for assign- ing relative weights to them. They can estimate how much income a typ- ical individual in the or Britain would need to produce the same change in stated happiness that comes from the well-being loss resulting from divorce ($100,000), or from job loss ($60,000), for example (Blanchflower and Oswald, 2004).

The Easterlin, in his original study, revealed a paradox that sparked interest in the topic but is, as of yet, unresolved. While most happiness studies find that within countries wealthier people are, on average, happier than poor ones, studies across countries and over time find very little, if any, relationship between increases in per capita income and average happiness levels. On average, wealthier countries (as a group) are happier than poor ones (as a group); happiness seems to rise with income up to a point, but not beyond it. Yet even among the less happy, poorer countries, there is not a clear relation- ship between average income and average happiness levels, suggesting that many other factors—including cultural traits—are at play (Figure 1).

4 Cross section work also typically yields low R-squares.

WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 45 Carol Graham = 0.14 2 R USA Japan Switzerland Netherlands Argentina New Zealand Ireland GDP per capita (1998 PPP) Uruguay Mexico Costa Rica Portugal Russia Brazil Columbia Chile Venezuela Hungary Bulgaria Peru Panama Paraguay El Salvador Guatemala S. Africa Bangladesh 2,000 Nicaragua Honduras Romania Nigeria 0 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000

90 80 70 60 50 40 30 20 10

100 % above neutral on life satisfaction life on neutral above % Figure 1: Happiness and income per capita, 1990s Source: Graham and Pettinato, 2002; Veenhoven, World Happiness Data Set, 2002 World Source: Graham and Pettinato, 2002; Veenhoven,

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Within countries, income matters to happiness (Oswald, 1997; Diener et al., 2003; among others). Deprivation and abject poverty in particular are very bad for happiness. Yet after basic needs are met, other factors such as rising aspirations, relative income differences, and the security of gains become increasingly important, in addition to income. Long before the economics of happiness was established, James Duesenberry noted the role of changing aspirations on income satisfaction, and its potential effects on and rates (Duesenberry, 1949). Any number of happiness studies has since confirmed the effects of rising aspirations, and have also noted their potential role in driving excessive consumption and other perverse economic behaviors (Frank, 1999). Once again, this is useful in interpreting divergent assessments of wel- fare in the globalization process. While many people are making income gains and are exposed to new opportunities, aspirations are also rising, both among those making gains and also those who are falling behind. The technological revolution and the widespread increase of global infor- mation, for example, have increased the awareness of millions of individ- uals, even in remote areas in poor countries. Thus in the instance of globalization, aspirations may be driven by new global reference norms, while opportunities are constrained by local conditions (for a summary of research on the topic, with evidence from Peru and Russia, see Graham, forthcoming). A common interpretation of the Easterlin paradox is that are on a “”: aspirations increase along with income, and after basic needs are met, relative rather than absolute levels of income matter to well-being. Another interpretation of the paradox is the psychologists’ “set point” theory of happiness, in which every individual is presumed to have a happiness level that he or she goes back to over time, even after major events such as winning the lottery or getting divorced (Easterlin, 2003). In this case, the implications for policy are that nothing much can be done to increase happiness. Individuals are remarkably adaptable, no doubt, and in the end can get used to most things, and in particular to income gains. The behavioral eco- nomics literature, for example, shows that individuals losses dispro- portionately to gains (see Kahneman, Diener, and Schwarz, 1999, among others). Easterlin argues that individuals adapt more in the pecuniary arena than in the non-pecuniary arena, while life changing events, such as

WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 47 Carol Graham bereavement, have lasting effects on happiness. Yet because most policy is based on pecuniary measures of well-being, it over-emphasizes the impor- tance of income gains to well-being, and underestimates that of other fac- tors, such as health, family, and stable employment. There is no consensus about which interpretation is most accurate. Yet numerous studies, which demonstrate that happiness levels can change significantly in response to a variety of factors, suggest that the research can yield insights into human well-being which provide important, if complementary, information for policymakers. Even under the rubric of set point theory, happiness levels can fall significantly in the aftermath of events like illness or unemployment. Even if levels eventually adapt upwards to a longer term equilibrium, mitigating or preventing the unhap- piness and disruption that individuals experience for months, or even years, in the interim certainly seems like a worthwhile objective for policy.

Selected applications of happiness economics

Happiness research has been applied to a range of questions. This chap- ter cannot undertake a comprehensive review. Instead, it provides a selec- tion of some of the questions the surveys can inform. These include the relationship between income and happiness; inequality and poverty—and their relation to the globalization process; the effects of macro-policies on individual welfare; and those of public policies aimed at controlling addic- tive substances. Some studies have attempted to isolate the effects of income from those of other endogenous factors, such as satisfaction in the work place. Studies of unexpected lottery gains find that these isolated gains have positive effects on happiness, although it is not clear that they are of a lasting nature (Gardner and Oswald, 2001). Other studies have explored the reverse direction of causality, and find that people with higher happiness levels tend to perform better in the labor and to earn more income in the future (Diener et al., 2003; and Graham, Eggers, and Sukhtankar, 2004). A related question, and one which is still debated in economics, is how income inequality affects individual welfare. Interestingly, the results dif- fer between developed and developing economies. Most studies of the U.S. and find that inequality has modest or insignificant effects on happiness. The mixed results may reflect the fact that inequality can be a

48 WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 The Economics of Happiness signal of future opportunity and mobility as much as it can be a sign of injustice (Alesina, DiTella, and MacCulloch, 2004). In contrast, recent research on Latin America finds that inequality is negative for the well- being of the poor and positive for the rich. In a region where inequality is much higher and where public institutions and labor markets are notori- ously inefficient, inequality signals persistent disadvantage or advantage, rather than opportunity and mobility (Graham and Felton, 2005). Happiness surveys also facilitate the measurement of the effects of broader, non-income components of inequality, such as race, gender, and status, all of which seem to be highly significant (Graham and Felton, 2005). These results find support in work in the health arena—which finds that relative social standing has significant effects on health outcomes (Marmot, 2004). Happiness research can deepen our understanding of poverty. The set point theory suggests that a destitute peasant can be very happy. While this contradicts a standard finding in the literature—poor people are less happy than wealthier people within countries—it is suggestive of the role that low expectations play in explaining persistent poverty in some cases. The procedural and capabilities approaches, meanwhile, empha- size the constraints on the choices of the poor. What is perceived to be poverty in one context may not be in another. People who are high up the income ladder can identify themselves as poor, while many of those who are below the objective poverty line do not, because of different expectations (Rojas, 2004). In addition, the well- being of those who have escaped poverty is often undermined by insecu- rity and the risk of falling back into poverty. Income data do not reveal the vulnerability of these individuals, yet happiness data show that it has strong negative effects on their welfare. Indeed, their reported well-being is often lower than that of the poor (Graham and Pettinato, 2002). The globalization process, meanwhile, mediates the effects of inequal- ity and poverty on well-being. Globalization is a major engine of growth, at least in the aggregate, and therefore plays a major role in reducing poverty. But globalization also introduces or exacerbates other factors that affect people’s well-being as much if not more than income growth. Happiness research can help us assess the extent of these effects (for detail, see Graham, forthcoming). An important such trend is the increas- ing of information about the living standards of others, both within

WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 49 Carol Graham and beyond country borders, which can result in changing reference norms and increased frustration with relative income differences, even among respondents whose own income is increasing. It also includes increased volatility and insecurity for many cohorts, particularly those that are not the best positioned to take advantage of new opportunities created by the opening of trade and capital markets. This insecurity, not surprisingly, con- tributes to negative perceptions of the globalization process, particularly in countries where there are very weak social insurance systems or where existing systems are eroding. Happiness research also shows that the same psychological factors that affect subjective evaluations of well-being also explain individuals’ ability to adapt to tremendous adversity and/or negative shocks and often even to return to previous levels of happiness. This process of adaptation—to either negative shocks or to the disruptions and changes that often accom- pany economic and development—is very much influenced by peoples’ norms about equity and perceptions of fairness. This helps to explain why there is often unexpected social stability in very poor soci- eties, and at the same time unexpected outbreaks of violence and social unrest in where there is a great deal of economic progress—but differential rewards to different cohorts. Tolerance of inequality seems to be much higher in contexts where there are perceived (even if not real) prospects for upward mobility. Downward mobility, or the threat thereof, is more likely to cause frustra- tion and social unrest than is persistent poverty (Graham and Pettinato, 2002; Graham, forthcoming). Relying on income measures of well-being alone can mask a tremendous amount of latent social unrest. Happiness surveys can also be used to examine the effects of different macro-policy arrangements on well-being. Most studies find that inflation and unemployment have negative effects on happiness. The effects of unemployment are stronger than inflation, and hold above and beyond those of foregone income (DiTella, MacCulloch, and Oswald, 2001). The standard “misery ”, which assigns equal weight to inflation and unemployment, may be underestimating the effects of the latter on well- being (Frey and Stutzer, 2002b). Political arrangements also matter. Much of the literature finds that both trust and freedom have positive effects on happiness (Helliwell, 2003; Layard, 2005). Research based on variance in voting rights across

50 WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 The Economics of Happiness cantons in Switzerland finds that there are positive effects from participat- ing in direct democracy. Research in Latin America finds a strong positive correlation between happiness and preference for democracy (Graham and Sukhtankar, 2004). Happiness surveys can also be utilized to gauge the welfare effects of various public policies. How does a tax on addictive substances, such as tobacco and alcohol, for example, affect well-being? A recent study on cig- arette taxes suggests that the negative financial effects may be outweighed by positive self-control effects (Gruber and Mullainathan, 2002). Recent research on obesity, meanwhile, uses happiness surveys to explore the role of norms and expectations in explaining the variance in obesity incidence across socioeconomic cohorts and across countries (Graham and Felton, 2005a). This research finds large differences in the well-being costs of obesity across cohorts, which are in turn linked to variance in incidence rates and in receptivity to public health messages.

Policy implications

Richard Layard (2005) makes a bold statement about the potential of hap- piness research to improve people’s lives directly via changes in public policy. He highlights the extent to which people’s happiness is affected by status—resulting in a rat race approach to work and to income gains, which in the end reduces well-being. He also notes the strong positive role of security in the workplace and in the home; and of the quality of social rela- tionships and trust. He identifies direct implications for fiscal and labor market policy—in the form of taxation on excessive income gains and via re-evaluating the merits of performance-based pay. While many economists would not agree with Layard’s specific recom- mendations, there is nascent consensus that happiness surveys can serve as an important complementary tool for public policy. Scholars such as Diener and Seligman (2004) and Kahneman, Krueger, and colleagues (2004) advocate the creation of national well-being accounts to comple- ment national income accounts. The nation of , meanwhile, has introduced the concept of “” to replace gross national product as a measure of national progress. Happiness research in countries in the process of integrating into the world , meanwhile, suggests that more emphasis should be

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placed on the negative effects of volatility and inequality, and on the vul- nerability of the near poor (Graham, forthcoming). The findings highlight the broader point that growth is a necessary but not sufficient condition for poverty reduction. Other key factors—such as public in health; institutions that can ensure adherence to basic norms of equity and fairness; and collective investments in social insurance to protect workers from the volatility that often accompanies integration into global mar- kets—are essential to sustaining the development gains that globalization helps bring about. While this policy conclusion is hardly a novel one, what is novel is the strong backing in individual welfare assessments rather than in a more general political or public policy debate. Despite the potential contributions that happiness research can make to policy, a sound note of caution is necessary in directly applying the find- ings, both because of the potential biases in survey data, and because of the difficulties associated with analyzing these kinds of data in the absence of controls for unobservable personality traits. In addition, happi- ness surveys at times yield anomalous results which provide novel insights into human psychology—such as adaptation and coping during economic crises—but do not translate into viable policy recommendations. One example is the finding that unemployed respondents are happier (or less unhappy) in contexts with higher unemployment rates. The posi- tive effect that reduced stigma has on the well-being of the unemployed seems to outweigh the negative effects of a lower probability of future employment (Clark and Oswald, 1994; Stutzer and Lalive, 2004; and Eggers, Gaddy, and Graham, forthcoming).5 One interpretation of these results for policy—raising unemployment rates—would obviously be a mistake. At the same time, the research suggests a new focus on the effects of stigma on the welfare of the unemployed. Happiness economics also opens a field of research questions which still need to be addressed. These include the implications of well-being find- ings for national indicators and patterns; the effects of happiness on behavior such as work effort, consumption, and ; and the effects on political behavior. In the case of the latter, surveys of unhappiness or frustration may be useful for gauging the potential for

5 Indeed, in Russia even employed respondents prefer higher regional unemployment rates. Given the dramatic nature of the late 1990s crisis, respondents may adapt their expectations downwards and are less critical of their own situation when others around them are unemployed.

52 WORLD ECONOMICS • Vol. 6 • No. 3 • July–September 2005 The Economics of Happiness social unrest—and their links to the globalization process—in various contexts. In order to answer many of these questions, researchers need more and better quality well-being data, particularly panel data, which allow for the correction of unobserved personality traits and correlated measurement errors, as well as for better determining the direction of causality (e.g. from contextual variables like income or health to happiness versus the other way around). These are major challenges in most happiness studies. Hopefully, the combination of better data and increased sophistication in econometric techniques will allow economists to better address these questions in the future.

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